Page 1 of 2 Stiglitz pinpoints 'moral' core of crisis
By Henry CK Liu
Nobel Laureate economist Joseph Stiglitz, a Roosevelt Institute senior fellow
and its chief economist, said on CNBC on January 19 that the US is infested
with "ersatz capitalism", a flawed, unfair system that socializes economic
losses and privatizes the gains. He decries the "moral depravity" that has led
to the current financial crisis.
Stiglitz served in the Bill Clinton administration as chairman of the Council
of Economic Advisers (1995-97) before moving to the World Bank as its chief
economist, where he developed a Pauline epiphany against the very
neo-liberalism he helped promote in the form of "the Third Way", to criticize
belatedly but rightly and vocally policies of the International Monetary Fund
(IMF). Such
outbursts put him in conflict with the Treasury Department under Larry Summers,
who reportedly forced Stiglitz to resign (2000), presumably for not being a
team player. Notwithstanding his government career setback, Stiglitz was
selected as a recipient of the 2001 Nobel Prize for Economics.
Despite heavy pressure from the Treasury to silent him, Stiglitz has been the
courageous voice of progressive economics, criticizing the structural defects
of central banking, deregulated free-market fundamentalism and predatory
globalization. Stiglitz is now a University Professor at Columbia and one of
the world's most respected and cited economists as a courageous defender of the
defenseless.
As Professor Stiglitz knows, the "moral depravity" he so detests about the
current financial crisis began much earlier.
I wrote on this site almost seven years ago (see
The Dangers of Derivatives, Asia Times Online, May 23, 2002): "The
financial crises faced by newly industrialized economies (NIEs) in the 1990s
were significantly different from the foreign debt crises in the developing
countries in the previous decade. Different forms of foreign funds flowed to
different recipients in developing countries during the two periods. More
importantly, derivatives emerged as an integral part of fund flows in the
1990s.
"Derivatives played an unprecedented key role in the Asian financial crisis of
1997, alongside the growth of fund flows to Asian NIEs, as part of financial
globalization in unregulated global foreign exchange, capital and debt markets.
Derivatives facilitate the growth in private fund flows by unbundling the risks
associated with financial vehicles, such as bank loans, stocks, bonds and
direct physical investment, and reallocating the risks more efficiently by
expanding the distribution and the level of aggregate risk. They also
facilitate efforts by many financial entities to raise their risk-to-capital
ratios to dodge regulatory safeguards, manipulate accounting rules and evade
taxation. Foreign exchange forwards and swaps are used to hedge against
floating exchange rates as well as to speculate on fixed exchange rate
vulnerability, while total return swaps (TRS) are used to capture 'carry trade'
profit from interest rate differentials between pegged currencies.
"Structured notes, also known as hybrid instruments, which are the combination
of a credit market instrument, such as a bond or note, with a derivative such
as an option or futures-like contract, are used to circumvent accounting rules
and prudential regulations in order to offer investors higher, though riskier,
returns. Viewed at the macroeconomic level, derivatives first make the economy
more susceptible to financial crisis and then quicken and deepen the downturn
once the crisis begins. Since investors can only be seduced to higher risk by
raising the return on higher risk, the quest for high return raises the
aggregate risk in the financial system. But investors always demand a profit
above their risk exposure which will leave some residual risk unfunded in the
financial system. It is in fact a socialization of unfunded risk with a
privatization of the incremental commensurate returns.
"The private global fund flows that led up to the crises of the 1980s were
largely in the form of dollar denominated, variable interest rate, syndicated
commercial bank loans to sovereign borrowers, recycling petro-dollar deposits
from OPEC [Organization of the Petroleum Exporting Countries] trade surpluses.
The formation of syndicates to underwrite these loans helped to bind lenders
together, and along with cross-default clauses in the loan contracts, it
greatly reduced individual banks' credit risks by passing such risk to the
banking system. Loan syndication amounted to a lender monopoly with open
price-fixing between previously competing banks.
"In order to reduce the banks' collective exposure to market risk, these loans
were issued as adjustable interest rate loans (usually priced as a spread above
LIBOR [London Interbank Offered Rate] or some short-term interest rate that
reflected banks' funding costs), and they were denominated mostly in dollars or
otherwise in other G-5 [Group of Five] currencies (which reflected the currency
denomination of the lending banks' funding sources). Foreign fund flows in this
form shifted most of the market risk to the borrowers, who might not have fully
understood that they bore both foreign exchange risk as well as interest rate
risk, and the spiraling exacerbating effect of the two risks on each other, ie,
rising dollar interest rates would devalue non-dollar local currencies which in
turn would push up local interest rates.
"Lending banks in the advanced financial markets of the 1980s, whose
liabilities were mostly short-term and denominated in the same currencies as
their loans to developing countries, bore little market risk. Their exposure
was almost entirely credit risk, and this was substantially mitigated through
the syndication of the loans and the inclusion of cross default clauses. Thus a
supposedly 'free' debt market transformed itself into a bilateral market
between powerless individual borrowers and an all-powerful lending monopoly. It
was the height of hypocrisy that in an era of blatant financial monopoly that
neo-liberal finance market fundamentalism achieved its unprecedented
intellectual ascendancy.
"The change in the distribution of market risk to Third World sovereign
borrowers laid the foundation for the crisis that began in August of 1982. The
crisis began when the Federal Reserve raised short-term dollar interest rates
to fight US run-away stagflation. Higher dollar interest rates, which served as
the basis for payments on adjustable rate loans, both increased the dollar
payments on loans and increased the cost in non-dollar local currencies for
dollars. Debtor countries were forced to drastically increase their foreign
borrowing in order to reduce the burden of servicing suddenly higher foreign
debt costs, leading to inevitable crisis.
"In August 1982, the Mexican government announced its inability to make
scheduled foreign loan payments. In response, the developing economy
governments, major money center banks, and the IMF and World Bank began
searching desperately for post-crisis recovery policies, initially by
rescheduling existing debt, arranging new lending and requiring the
developing-economy governments to implement austere fiscal and monetary
policies to make possible the eventual repayment of the continuously growing
debt burden, but in effect foreclosing developing economies any prospect of
growth with which to repay the still mounting foreign loans. The foreign
creditors were protected; the debtor developing nations lost what little they
had gained in the previous decade and then some, with no prospect of ever
escaping from the tyranny of foreign debt in the foreseeable future.
Neo-liberal economists cited Shakespeare: 'Better to have loved and lost, then
not to have loved at all', while their paying clients laughed all the way to
the bank.
"The Asian financial crises that began in 1997 were very different phenomena.
They were caused by hot money (short-term foreign credit based on over-valued
exchange rates that were defended beyond reason by Third World monetary
authorities poisoned by neo-liberal advice). Derivatives trading in
over-the-counter (OTC) markets were, and still are, neither registered nor
systematically reported to the market. Thus the full risk exposure in the
system is not known until the crisis hits. In macroeconomic terms, derivatives
have the structural effect of privatizing the incremental efficiency (profits)
while socializing the risk (losses) associated
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
